Statement 133 Implementation Issue No. F7

The following questions involve the use of
collar-based hedging instruments in fair value hedge
transactions:

In applying paragraph 20(c), does an entity
have the flexibility to exclude the time value of the hedging
written option (or net written option) and consider only the change
in its intrinsic value in measuring the potential gain or loss on
the combination of the written option (or net written option) and
the hedged item?

Must the special written-option test in paragraph 20(c) be
applied both at inception and throughout the entire term of the
hedging relationship?

BACKGROUND

An entity enters into an equity price collar with an
investment bank to hedge the fair value exposure of an equity
security that it holds as an available-for-sale security. That
collar is indexed to the price of the equity security held and
consists of a purchased put with the strike price equal to $40 per
share (whereby the holder can put the equity security to the
investment bank for $40 per share) and a written call with the
strike price equal to $60 per share (whereby the investment bank
can call the equity security from the holder for $60 per share).
The collar has the effect of insulating the equity security holder
from any losses caused by equity price decreases below $40 per
share, but the holder must sacrifice any unrealized gains caused by
equity price increases above $60 per share. The hedged equity
security has a fair value of $50 per share at inception of the
collar. If the underlying increases by 50 percent to $75, the
intrinsic value of the collar will decrease from zero to a loss of
$15 per share ($75 - $60). If the underlying decreases by 50
percent to $25, the intrinsic value of the collar will increase
from zero to a gain of $15 per share ($40 - $25). Despite the
symmetrical changes in the intrinsic value of the collar in
response to an upward and a downward change in the equity index by
the same percentage, the market views the likelihood that the
underlying equity price will increase as greater than the
likelihood that it will decrease. Accordingly, the investment bank
is willing to pay a premium to the equity security holder.

The following table shows the calculation of the gain
and loss for a market price move of 50 percent. (The special
written-option test in paragraph 20(c) requires consideration of
all possible percentage favorable changes in the underlying
(from zero percent to 100 percent) and all possible
percentage unfavorable changes in the underlying.)

Table: Potential Gain and Loss on the Combination
of the Hedged Item and the Net Written Option If the Market Moves
Each Direction by the Same Percentage

(The time values of the options were selected to
emphasize importance of the Issue.)

Inception

Price Move up 50%

Price Move down 50%

Purchased Put
Intrinsic Value
Time Value

-

$4

-

$2

$15

1

Fair Value

4

2

16

Written Call
Intrinsic Value
Time Value

-

(6)

(15)

(4)

-

(4)

Fair Value

(6)

(19)

(4)

Equity Security

50

75

25

Combined Fair Value

$48

===

$58

===

$37
===

Gain

Loss

Change in Fair Value of Combination from
Inception
Percentage Change in Fair Value of
Combination From Inception

$10

21%

$(11)

-23%

Paragraph 20(c) discusses the use of written options
in fair value hedges and states the following:

If a written option is
designated as hedging a recognized asset or liability, the
combination of the hedged item and the written option provides at
least as much potential for gains as a result of a favorable change
in the fair value of the combined instruments as exposure to losses
from an unfavorable change in their combined fair value. That test
is met if all possible percentage favorable changes in the
underlying (from zero percent to 100 percent) would provide at
least as much gain as the loss that would be incurred from an
unfavorable change in the underlying of the same percentage.
[Footnote reference omitted.]

Subparagraph 20(c)(1) states in part the
following:

A combination of
options...entered into contemporaneously shall be considered a
written option if either at inception or over the life of the
contracts a net premium is received in cash or as a favorable rate
or other term. (Thus, a collar can be designated as a hedging
instrument in a fair value hedge without regard to the test in
paragraph 20(c) unless a net premium is received.)

RESPONSES

Question 1

Yes. The time value of the written option (or net written option)
may be excluded from the special written-option test in paragraph
20(c) provided that, in defining how hedge effectiveness will be
assessed, the entity specifies that it will base that assessment on
only changes in the option's intrinsic value. Therefore, the change
in the time value of the options would be excluded from the
assessment of hedge effectiveness in accordance with paragraph
63(a). Accordingly, when applying the special written-option test
to determine whether there is symmetry of the gain and loss
potential of the combined hedged position for all possible
percentage changes in the underlying, an entity is permitted to
measure the change in the intrinsic value of the written option (or
net written option) combined with the change in fair value of the
hedged item.

Pursuant to paragraph 20(c)(1) and the guidance in
Statement 133 Implementation Issue No. E2, "Combinations of
Options," the combination of options in the example collar in the
Background section is a net written option from the equity security
holder's perspective. Therefore, the special written-option test in
paragraph 20(c) must be applied to determine whether the hedging
relationship between the equity security and the collar qualifies
for fair value hedge accounting. That test requires consideration
of the potential gain and loss on the combined collar and equity
security for all percentage changes in the equity index.
Performance of that analysis demonstrates that the combination of
the hedged item's price change and the net written option's
intrinsic value change provides at least as much potential for
gains as a result of a favorable change in their respective prices
as exposure to losses from an unfavorable change in their
respective prices.

The calculations in the table in the Background
section demonstrate that the example hedging relationship would
fail the written-option test in paragraph 20(c) if the time value
were required to be considered. The amount of the gain and the loss
on the combination of the net written option (both time value and
intrinsic value) and the equity security when the underlying equity
price increases and decreases by the same percentage is not
equivalent or symmetrical. That outcome is due to the fact that the
purchased put and written call have different time values, and for
a specific change in the underlying, the relative change in time
value for each option will be different.

Question 2

No. The special written-option test in paragraph 20(c) must be
applied only at inception of the hedging relationship. Otherwise,
collar-based hedging relationships would generally fail the
symmetry test as the underlying moves in a manner that causes the
written-option portion of the collar to approach having intrinsic
value. Therefore, a requirement to apply the symmetry test in
paragraph 20(c) on an ongoing basis would effectively prohibit
collar-based hedging relationships from receiving hedge accounting
for the written-option portion of the collar.

The above response has been authored by the FASB
staff and represents the staff's views, although the Board has
discussed the above response at a public meeting and chosen not to
object to dissemination of that response. Official positions of the
FASB are determined only after extensive due process and
deliberation.